MA

Absorption and Marginal Costing

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The treatment of fixed production overheads
Treatment of production
Marginal overheads varies:
costing vs. • Absorption costing
absorption allocates both fixed and
costing: variable overheads to
Different each unit. Direct costs
methods for • Marginal costing remain
valuing unit assigns only variable constant in
costs. overheads to each unit. both methods.

Basic unit cost Fixed production overheads:

includes direct • Absorption costing: Included in
costs. unit cost.
• Marginal costing: Treated as
period costs.

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Marginal costing
Marginal costing focuses on the cost of producing one additional
unit of a product or service.
It includes variable costs like direct materials, direct labor, direct
expenses, and variable production overheads.
Fixed overhead costs are not included in inventory valuation; they
are treated as period costs.

Marginal costing is a key technique used in decision making.

It helps management focus on the changes resulting from the

decision under consideration.

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The contribution concept
The contribution concept lies at the heart of marginal costing. Contribution can be
calculated as follows:
Contribution = Sales price - All variable costs
Illustration
The following information relates to a company that makes a single product - a desk lamp

Per lamp Sales of 1,000 Sales of 1,500

lamps lamps
$ $ $ $ $
Sales revenue 600 600,000 900,000
Direct materials 200 200,000 300,000
Direct labour 150 150,000 225,000
50 50,000 75,000
Variable production overheads

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The contribution concept
Per lamp Sales of 1,000 Sales of 1,500
lamps lamps
Marginal cost of production (400,000) (600,000)

Contribution 200,000 300,000

Fixed production overheads (120,000) (120,000)

Total profit 80,000 180,000

Contribution per lamp 200 200

Profit per lamp 80 120

Fixed costs have been estimated to be $120,000 based on a production level of 1,000 lamps and it expected to remain at
this level.
Profit per lamp has increased from $80 when 1,000 lamps are sold to $120 when 1,500 lamps are sold.
Contribution per lamp has remained constant at both levels of sales.

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The contribution concept
Profit per unit depends on sales volume, making it unsuitable for short-term
decisions.

Management accountants often use the contribution concept.

Contribution represents the amount available to cover fixed costs.

Contribution per unit remains constant across different output levels.

Formula: Contribution per unit = Sales price per unit - Total variable cost per
unit.

Total contribution = Contribution per unit × Sales volume.

Profit is calculated as Total contribution minus Fixed overheads.

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Marginal costing statement of profit or loss
In order to be able to prepare a statement of profit or loss under marginal costing, you
need to be able to complete the following proforma :
$ $
Sales X
Less Cost of sales:
Opening inventory X
Variable cost of production X
Less closing inventory (X)
(X)
X
Less Other variable costs (X)
Contribution X
Less fixed costs (X)
Profit/loss X
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Marginal costing statement of profit or loss
Inventory valuation: Opening and closing inventory valued at marginal
(variable) cost in marginal costing.

Fixed costs: Deducted from contribution to determine profit; considered period

costs.

Statement structure: Split into variable costs before contribution and fixed
costs after contribution.

Note: Only production variable costs included in cost of sales and inventory
valuation; non-production variable costs deducted before contribution.

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Advantages and disadvantages of marginal
costing
Advantages of Marginal Costing:
• Constant contribution per unit facilitates easy analysis.
• Eliminates under or over absorption of overheads,
simplifying profit calculations.
• Fixed costs are treated as period costs, aiding period-based
analysis.
• Facilitates straightforward decision-making processes.

Disadvantages of Marginal Costing:

• Closing inventory valuation may not align with IAS 2
principles.
• Fixed production overheads are not allocated across units,
impacting cost distribution.

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Absorption costing
Absorption costing builds up a full product cost by adding
direct costs and a portion of production overhead costs.

It uses overhead absorption rates to allocate overhead costs

to products.

Each unit of inventory is valued at its production cost,

including allocated overhead.

The cost per unit (overhead absorption rate) is calculated by

dividing budgeted production costs by budgeted activity.

This method helps in understanding the total cost of

production for each unit.
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Absorption costing statement of profit or loss
In order to be able to prepare a statement of profit or loss under absorption costing, you need to be able to
complete the following proforma:
$ $
Sales X
Less: Cost of sales:
Opening inventory X
Variable cost of production X
Fixed overhead absorbed X
Less closing inventory (X)
(X)
X
(under)/ Over-absorption (X)/X
Gross Profit X
Less Non-production costs (X)
Profit/Loss X
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Absorption costing statement of profit or loss
• Opening and closing inventory valued at full
Inventory production cost.
Valuation:

Under/Over- • Adjustment required for under or over absorption of

absorbed overheads.
Overhead:

• Absorption costing statements divided into:

Cost Split: • Production costs in the cost of sales.
• Non-production costs after gross profit.

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Advantages and disadvantages of absorption
costing

Advantages of Absorption
Costing:
• Includes fixed production
overheads in inventory values (in
Disadvantages of Absorption
accordance with IAS 2). Costing:
• Analyzing under/over absorption • More complex to operate than marginal
of overheads helps control costs. costing.
• Provides less useful information for
short-term decision making.

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Absorption versus marginal costing
Marginal costing values inventory based on variable production cost per unit.

Absorption costing values inventory based on full production cost per unit.

This leads to different inventory values at the beginning and end of a period.

Different inventory values affect profits reported in the statement of profit or loss.

Profits calculated using marginal costing differ from those using absorption costing.

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Reconciling profits reported under the
different methods
Profits differ under absorption and marginal costing when
inventory levels change.

Absorption costing gives higher profit when inventory levels

increase.

Marginal costing gives higher profit when inventory levels

decrease.

Both methods give the same profit when inventory levels are
constant.

Acronym: SIAM - Stock Increasing Absorption More.

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Alternative Costing Principles

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Activity based costing (ABC)
Activity based
costing (ABC)
is an Cost pools A cost driver ABC absorbs
alternative represent is a unit of overhead
approach to activities that activity that costs into
product consume consumes units using
costing. resources. resources. cost drivers

ABC Each cost pool Cost

allocates should have a drivers
overhead corresponding influence
costs to cost driver. the level
cost pools of cost.
based on
activities.

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ABC versus Absorption costing

Absorption Costing: Activity-Based Costing (ABC):

• Overhead absorption rate based on • Does not use departments for cost
machine hours. gathering.
• Machine department absorbs costs like • Groups costs into "cost pools" based on
power, maintenance, and depreciation. activities.
• Also absorbs share of rent, rates, • Each activity (e.g., power usage,
heating, and lighting based on machine machine depreciation, maintenance)
hours. has its own pool.
• Machine hours not directly responsible • Machining department only absorbs
for all absorbed costs. costs directly related to its activities.
• Personnel costs, rent, and rates charged
to separate activities.

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ABC versus Absorption costing
Examples of ABC
• Cost drivers in production include setup machinery costs driven by
the number of setups or batches produced, and running machine
costs driven by machine hours.
• Order processing costs are related to the number of orders
dispatched or the weight of items dispatched.
• Purchasing costs are related to the number of purchase orders made.
• ABC (Activity-Based Costing) flexibility reduces arbitrary
apportionments.
• ABC leads to more accurate product and service cost calculations

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Advantages and Disadvantages of ABC
More accurate cost per unit
Advantages of
ABC Improved pricing, sales strategy, performance management, and decision making

Better insight into overhead cost drivers

Recognition that overhead costs are not solely related to production and sales
volume
Ability to manage overhead costs by identifying and controlling cost drivers

Applicability in complex business environments

Ability to calculate realistic costs

Applicability to all overhead costs, not just production

Suitable for both product and service costing

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Advantages and Disadvantages of ABC
Disadvantages of Limited benefit if overhead costs are primarily volume-
ABC related or small proportion of overall cost.
Inability to allocate all overhead costs to specific
activities.

Potential for inappropriate choice of activities and

cost drivers.
Complexity in explaining ABC to stakeholders.

Uncertain benefits may not justify implementation

costs.
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Target Costing
• Target costing is a product cost estimation
method.
Target Costing • It involves subtracting a desired profit margin
from a competitive market price.
Overview: • The goal is to achieve this cost by the mature
production stage.
• Internal approach where costs are built up
based on production expenses.
Conventional Costing • Selling price is determined by adding a margin
to the production cost.
Approach: • Ignores external market conditions and
competitor pricing.

• Designed to address limitations of

Purpose of Target conventional costing.
• Considers market demand and competitor
Costing: prices.
• Aims to ensure competitiveness in pricing.

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Target Costing
• Starts with estimating a selling price to capture
market share.
Process of Target • Deducts desired profit to determine target
cost.
Costing: • All departments collaborate to achieve the
target cost.

• Conventional: Bottom-up, starting with

internal costs.
Approach Comparison: • Target Costing: Top-down, starting with a
target price.

• Value analysis and/or value engineering

Tools for Cost used to reduce costs.
Reduction: • Collaboration among departments crucial
for cost-saving initiatives.

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Life Cycle Costing
• Life cycle costing: Tracks and accumulates actual costs and revenues for each product from start to finish.
• Technique: Compares product revenues with all incurred costs throughout the entire product life cycle.
The Product Life Cycle
• The product life cycle suggests that all products pass through a number of stages from development to
decline and is the basis for life cycle costing.

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Life Cycle Costing
Development • Product not yet sold
• Development costs creating loss
Stage:
Introduction • Low sales volume
• Product establishing in market
Stage: • Limited customer awareness or reluctance to try

• Rapid increase in sales

Growth Stage: • Consumers becoming more familiar

• Sales at high level

Maturity Stage: • Possible need for modification to avoid decline

• Sales decrease
Decline Stage: • Pace of decline likely to increase
• Reasons include outdatedness or competition from new products

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Life Cycle Costing

The advantages of life cycle costing are:

• The forecast profitability of a given product over
its entire life is determined before production
begins
• Accumulated costs at any stage can be
compared with life cycle budgeted costs,
product by product, for the purposes of
planning and control.

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Life Cycle Costing
Traditional accounting systems focus on periodic reporting, whereas life cycle
costing considers revenues and costs accumulated over the entire life cycle of a
product.

Life cycle costing allows for more effective resource allocation by recognizing the
commitment needed throughout the product's life cycle.

Traditional accounting treats research and development, design, production setup,

marketing, and customer service costs as aggregated expenses, while life cycle
costing traces these costs to individual products for better comparison with later
revenues.

Life cycle costing helps identify relationships between early decisions on product
design and production methods and their impact on ultimate costs.

With decreasing product lives, monitoring pre-production and early stage costs
on a product-by-product basis becomes crucial.

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Life Cycle Costing
Design costs are significant in a product's lifecycle, with about
70% incurred during design and development.
• Decisions made in design impact future costs (components, production
methods).
• Collaboration across functions minimizes costs over the lifecycle.
• Value engineering is crucial for cost reduction.

Time to market must be minimized due to intense competition.

• Quick entry into the market is essential to establish and profit from a product.
• Competitors closely watch each other for new product launches.
• Early launch allows more time for market establishment and profit generation.
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Maximise the length of the life cycle itself:
Maximise life cycle for greater profit

Quick market entry extends profit generation time

Find other uses/markets for product

Plan staggered entry into different markets

Staggered launch reduces costs, increases revenue

Example: Some films released in USA before UK

Builds enthusiasm, increases overall revenue

Some companies stagger launch due to budget constraints

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The implications of life-cycle costing
• Pricing decisions can be based on total life-cycle costs.
Pricing:

• Life-cycle cost analysis guides decisions on product production.

• Helps allocate costs for cost recovery; non-recovery signals product reconsideration.
Decision • Analysis reveals interconnections between business functions.
Making:

• Early-stage decisions greatly impact 90% of a product's life-cycle costs.

• Tight control over development stage costs (e.g., R&D) is crucial.
Performance • Enhanced reporting traces costs (e.g., R&D, marketing) to individual products for better
Management: comparison with revenues.

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